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A Currency-Issuing Government Spends on its Own Terms

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An alternative title to this post could have been, ‘The Interest Rate on Public Debt is a Policy Variable’. This remains true even though, in the neoliberal era, governments usually require themselves to follow various unnecessary rules on how their spending is to be conducted. These rules typically serve no public purpose but may have the effect of misleading the public into believing that somehow a currency issuer can run out of the currency that it alone is empowered to create. Consider a currency-issuing government that requires itself either to collect taxes or to issue debt to non-government before it spends. This is quite typical of governments today. At first glance, these requirements may seem problematic. From inception, it would clearly be impossible for a currency issuer to

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An alternative title to this post could have been, ‘The Interest Rate on Public Debt is a Policy Variable’. This remains true even though, in the neoliberal era, governments usually require themselves to follow various unnecessary rules on how their spending is to be conducted. These rules typically serve no public purpose but may have the effect of misleading the public into believing that somehow a currency issuer can run out of the currency that it alone is empowered to create.

Consider a currency-issuing government that requires itself either to collect taxes or to issue debt to non-government before it spends. This is quite typical of governments today. At first glance, these requirements may seem problematic. From inception, it would clearly be impossible for a currency issuer to receive tax payments in its own currency or to auction off public debt in the form of treasuries in exchange for its own currency before the currency itself has actually been issued. The resolution to this apparent conundrum is that government can always (and currently does) advance to non-government the currency it requires to purchase newly issued public debt.

More specifically, the central bank, as the monetary arm of government, issues currency in the form of reserves (by crediting reserve accounts) while requiring collateral in the form of previously issued treasuries. Non-government is then in a position to purchase newly issued treasuries at the Treasury auction, with reserve accounts debited in payment.

Typically, there will be a bidding process at the Treasury auction. The treasuries will go to the participants with successful bids – all those bids that offer an interest rate on government debt that is at or below the cutoff. If the central bank is prohibited from purchasing treasuries directly from the Treasury (which may or may not be the case, depending on the country in question), it will be necessary to auction off all newly-issued treasuries to non-government. In that case, the cutoff between successful and unsuccessful bids will be determined in the auction itself.

Considering the sale of public debt may be subject to a bidding process, it may be wondered how government can dictate the terms on which it spends. In particular, it may be unclear what prevents the rate of interest on public debt from rising above the rate that government actually wants to pay.

The answer is very simple. The central bank can always purchase financial assets in the secondary market (the market for previously issued financial assets) so as to drive down the interest rates (yields) on those assets. The more the central bank’s actions drive down interest rates, the more attractive newly issued treasuries become in comparison. Since the central bank can credit reserve accounts without limit, there is never any risk whatsoever of the government somehow being forced to pay an interest rate on its debt that it is not fully prepared to pay. If the government wants the interest rate on newly issued treasuries to be lower than it otherwise would be, the central bank will simply inject more reserves into the system in exchange for financial assets purchased in the secondary market, thereby driving down the interest rates applicable to financial assets seen as close alternatives to newly issued treasuries.

Since both reserves and newly issued treasuries have zero default risk, and since reserves offer less interest than treasuries, there will be a willingness within non-government to exchange reserves for treasuries.

A Simple Representation

Consider a simplified model in which there are only three types of financial assets: reserves (R), treasuries (T) and some other financial asset (O). Assume the interest rate on reserves is zero. Assume the risk premium on the other financial asset is ρ.

Participants in a Treasury auction will not be willing to accept an interest rate on treasuries that is less than the risk-adjusted return on the other (alternative) financial asset. As a result, the interest-rate bid on T (ib) will tend to be set equal to the interest rate on O (io) minus the premium for the riskier asset:

ib = io – ρ

If the bid at the Treasury auction looks likely to be higher than the government desires, the central bank need only drive down the interest rate on O by purchasing financial assets in the secondary market. It can achieve this indirectly by buying previously issued treasuries. This injects additional reserves into the system, leaving more funds in search of a higher return and putting downward pressure on all yields, including for O. For a given risk premium, the consequent reduction in io results in a lower ib at the Treasury auction.

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